IN RESPONSE TO THE DISCUSSION PAPER ISSUED BY THE U.S. TREASURY DEPARTMENT ENTITLED “SELECTED TAX POLICY IMPLICATIONS OF GLOBAL ELECTRONIC COMMERCE”

NOVEMBER 5, 1997

INTRODUCTION

On November 21, 1996, the United States (the "U.S.") Treasury Department (the  “Treasury”) issued a discussion paper (the “Treasury Paper”) as above titled which explores the issues that could arise out of the technological explosion that has radically changed business practices.  Many activities that take place in today’s commercial or industrial enterprises are conducted electronically.  The Treasury Paper identifies the potential tax issues, but it is not intended to interpret current law or to make any recommendations as to how the law should be altered in the future, if at all, to address those issues.  The Treasury’s Office of International Tax Counsel invited comments from interested parties, which are available to the public.

The United States Council for International Business (the "USCIB") is pleased to submit its comments.  The USCIB advances the global interests of American business both at home and abroad.  It is the U.S. affiliate of the International Chamber of Commerce (the "ICC"), the Business and Industry Advisory Committee (the "BIAC") to the Organization for Economic Cooperation and Development (the "OECD"), and the International Organization of Employers (the "IOE").  As such, it officially represents the position of U.S. businesses with the U.S. government and with foreign governments.  The USCIB addresses a broad range of policy issues with the objective of promoting an open system of world trade, finance and investment, in which business can flourish and contribute to economic growth and human welfare.  Recently the USCIB established a new position, Director of Electronic Commerce, to coordinate our members’ efforts to develop and articulate a consensus on the many policy issues which will arise as use of the electronic medium expands as a means to conduct commerce.  Thus, the tax policy aspects of doing business electronically are the responsibility of our Taxation Committee and our Director of Electronic Commerce.

GENERAL ISSUES

The Treasury Paper raises substantive issues as well as certain compliance and administrative issues.  The Treasury Paper strongly promotes the principle of neutrality, i.e., the tax system should treat economically similar income similarly, whether earned electronically or through traditional non-electronic means.  The USCIB supports this position.  The Treasury Paper asserts that the best way to achieve neutrality is through the adaptation of existing tax principles and rules rather than the introduction of a new tax regime.  The USCIB also supports this position.  The paper correctly points out that a technical understanding of the Internet is required to fully appreciate the tax issues presented by electronic commerce.  Section 6 of the Treasury Paper does a credible job of highlighting the characteristics of the Internet that are relevant to a discussion of both the substantive and administrative tax issues.

Addressing this subject requires an international perspective, since electronic commerce potentially cuts across national boundaries to a greater degree than traditional forms of commerce.  Accordingly, no nation should create a new regime or alter its existing regime to accommodate electronic commerce without serious consideration as to the impact on its trading partners.  An international solution must be sought, and the U.S. should continue to manifest its leadership in electronic commerce by strongly promoting an internationally accepted approach to the taxation of electronic commerce.  We believe that the OECD is the most appropriate forum to sponsor the required international dialogue.  The OECD's coordination of such an effort will help achieve the dual goals of avoiding international double taxation and creating a climate of greater certainty.  

SIGNIFICANT ISSUES AND QUESTIONS

Following are the significant issues addressed by the Treasury Paper:

·         Basis of taxation — global taxation for residents versus source taxation for nonresidents

·         U.S. trade or business/permanent establishment — establishing a taxable nexus for foreign taxpayers in the U.S.

·         Classification of income — the tax treatment for transactions that use the electronic medium to effect the transfer of  information that can be digitized

·         Services income — the possibility of changing the source rule for services

·         Global allocation of income and expenses — the approach to dealing with global trading

·         Administrative and compliance matters — the steps necessary to preserve the auditability of tax returns without imposing burdensome information return requirements on taxpayers

BASIS OF TAXATION

The Treasury Paper asserts that, in recent years, there has been a move toward greater reliance on residence-based taxation and a shift away from source-based taxation.  Generally, the U.S. Internal Revenue Code (the “Code”) taxes U.S. residents on their worldwide income, irrespective of character or source.  Conversely, most nonresidents are taxable on a source basis only.  Under this regime, all income earned by nonresidents which is “effectively connected” with a U.S. trade or business is subject to U.S. income tax at the rates applicable to U.S. business.  Effectively connected income is primarily U.S. source income, although the Code provides exceptions for three circumscribed categories of foreign income.  In addition, the Code imposes a special nonresident income tax (i.e., withholding tax) on the U.S. source passive income of nonresidents which is not effectively connected to a U.S. business, generally referred to as “fixed and determinable annual and periodic income.”  In the case of a resident of a treaty partner engaging in business activities in the U.S., the relevant treaty increases the level of activities that such  nonresident business can conduct before it is deemed to have a taxable U.S. presence.  Treaties generally require that a nonresident have a “permanent establishment” through which the business is conducted, and to which the income is attributable, before the income is considered to be “effectively connected.”

The USCIB supports the retention of the existing system.  We believe that it has operated with reasonable effectiveness since its enactment in 1966.  We have not observed any trend in U.S. tax law or policy toward a heavier emphasis on residence- based taxation, particularly as it relates to the tax regime for nonresidents.  Accordingly, we do not believe that the ascendancy of residence-based taxation is a natural evolutionary trend in U.S. tax policy.

In the 30 years in which the current regime for taxing foreign persons has been in force, the rules have had to accommodate changing fact patterns.  We believe was that that was accomplished with a minimum of difficulties.  The advent and growth of electronic commerce is, in our view, merely another factual change.  The use of the Internet will permit nonresidents to conduct certain types of transactions in a foreign location (e.g., product sales and services) without the physical presence in the host country that was previously required.  As a result, the host country may lose the tax revenue formerly associated with these types of transactions, leaving the residence country with sole taxing jurisdiction.  From a factual perspective, it may seem that the scales are tipping toward residence-based taxation, but this is occurring without the addition of amendments to the Code.  We believe that such amendments would represent bad tax policy.

Accelerating a move toward residence-based taxation through statutory amendments is likely to meet with disapproval in many countries, particularly less developed countries.  These nations tend to favor rules that better protect their revenue base which translates into a heavy reliance on source based taxation vis-à-vis foreign taxpayers.  Such a situation highlights the need for an international consensus on this issue.  Although we advocate the retention of the existing U.S. system and its balance between residence- based taxation and source-based taxation, we feel strongly, as noted above, that reaching an internationally endorsed and accepted solution is paramount to achieving the primary goal of avoidance of international double taxation.

U.S. TRADE OR BUSINESS/PERMANENT ESTABLISHMENT

 Under the Code, a nonresident alien and/or foreign corporation is subject to U.S. taxation on all income effectively connected with a U.S. trade or business.  This includes effectively connected passive income (e.g., interest, dividends, royalties, etc.) which otherwise would be subject to a nonresident withholding tax at a 30% (or lesser treaty) rate.  The Code does not provide an expansive definition of what constitutes a “U.S. trade or business,” leaving this key phrase open to interpretation.  In addition, the Internal Revenue Service (the "IRS") issues specific rulings which assist taxpayers in determining when they are so engaged.

The bilateral tax treaties to which the U.S. is a signatory generally provide a different threshold for establishing a taxable nexus in the U.S. (i.e., “permanent establishment”).  Under this test, merely engaging in business activities in the U.S. will not necessarily establish a taxable presence as might be the case under the Code.  The business activities must be carried out by, or through, a permanent establishment that the foreign taxpayer maintains in the U.S.  A permanent establishment is a substantial presence, physically situated in the U.S., that actively carries on business here (e.g., an office, a branch, a manufacturing facility, inter alia etc.).  In addition, certain types of  agency arrangements can also create a permanent establishment of a foreign principal.

The underlying motivation to reconsider this area of the Code is that electronic commerce enables foreign persons to engage in business transactions with U.S. customers from any jurisdiction without creating a traditional permanent establishment in the U.S.  For example, the sale of goods by a foreign supplier can be transacted on the Internet, including the offer, the acceptance of the offer, the arrangement of the terms and conditions of the sale, and the payment, without the use of a U.S. employee or agent.  A server (i.e., a computer storing the data that the customer would require to enter into the transaction) used by a foreign supplier to transact this type of business can be located almost anywhere.  Accordingly, many types of business enterprises, especially those selling products, may be in a position to operate in the U.S. without engaging in activities that would constitute the conduct of a U.S. trade or business or giving rise to a permanent establishment.  Such a transaction may formerly have required the foreign business to set up an office in the U.S. to exploit the market to any substantial degree.  

The USCIB recognizes that, in an international business, the increased capacity to carry on activities in the residence country is not a new phenomenon, but the continuation of an ongoing trend.  Sophisticated technological innovations, which have made possible the advances in transportation, communications and, more recently, electronic commerce, inter alia, have made it far easier to conduct a business remotely.  The advent of electronic commerce has merely accelerated this trend.  Moreover, whether a business can exploit the U.S. market to the maximum extent possible via the Internet without establishing a business presence depends upon the particular facts and circumstances of each case.  In our view, however, there will be many businesses that will continue to carry on activities through a physical presence in the U.S. to maximize their market penetration which perhaps may not be accomplished solely through the electronic medium.

Based on the above, the USCIB sees no compelling need to amend the Code or revise existing regulations with regard to the regime governing the tax treatment of foreign taxpayers engaging in a U.S. trade or business.  Some taxpayers may be able to operate remotely via the Internet, so as to potentially avoid U.S. taxation under the current rules.  Of such taxpayers, most, if not all will be taxed on the income in their home countries, possibly at a rate of tax at least as high as that of the U.S.

We concur with the suggestion contained in footnote 52 of the Treasury Paper that the statutory threshold for establishing a taxable business presence in the U.S. be amended to conform with the permanent establishment concept as contained in the U.S. model treaty.  Although this would require the drafting of several technical amendments to the Code, it would not represent a major conceptual change.  The implementation of such an approach would create greater consistency and certainty for foreign taxpayers, particularly those from non-treaty countries.  Moreover, we do not think that amending the Code in this manner would result in the sacrifice of a “bargaining chip” in treaty negotiations, as today there are many more critical issues in such negotiations.

CLASSIFICATION OF INCOME

The Treasury Paper states that many types of information can be digitized and transmitted electronically, including computer programs, books, music and other types of images (e.g., motion pictures, video tapes, etc.).  The paper points out that a purchaser could be restricted to using the purchased information itself, could be granted the right to make a limited number of reproductions, perhaps for internal distribution to its affiliates, or could be granted the right to reproduce the information for resale to a mass market.  The Treasury Paper also notes that these types of transactions have been occurring for many years in traditional formats before the popular use of the electronic medium began to take hold.  Undoubtedly, they will continue to be consummated both in electronic and non-electronic form.  The Treasury stresses that any changes to be effected in the tax rules involving these data transfers   must be applied to traditional (i.e., non-electronically generated) transactions as well as their electronic counterparts in order to ensure neutrality of treatment.  As noted previously, the USCIB strongly endorses the concept of neutrality.

The Treasury Paper concludes that technology makes it far easier to reproduce and disseminate information that can be digitized, with a view toward changing the rules governing the classification of income.  The USCIB believes that new rules are notnecessary.  The ability to handle data transfers electronically is a factual change which can be accommodated under existing U.S. tax rules.  Facts and circumstances have always played a large part in determining the tax consequences of business activities and business transactions.  Electronic transmission of data is just another factual change in the manner in which such data is transmitted.  The example in the Treasury Paper (paragraph 7.3.2) involving the customer who acquires ten copies of a particular book by receiving one copy electronically with the right to reproduce nine additional copies illustrates clearly how a “facts and circumstances” approach could work.  The Treasury Paper speculates that the transaction might generate royalty income because the right of the purchaser to reproduce the additional nine copies is usually a right reserved to a copyright holder or a licensee.  Nonetheless, looking at the substance of the transaction it is clear that this transaction constitutes a sale of ten books, and it should be so treated for tax purposes.  At most, some examples could be inserted in the appropriate regulations to cover basic transactions that could arise in practice, but we do not see a need for formulating new income classification rules.

In its paper, the Treasury refers to the proposed regulations on computer program transactions.  The USCIB submitted comments with respect to the international application of these proposals.  We view the proposed regulations as a reasonable approach to income classification of certain electronic transactions, and we would support the application of the final regulations to comparable transactions involving the information transmissions contemplated in this section of the Treasury Paper.

In addition to the potential confusion between sales income and royalty income, the Treasury also discusses how digitized information could present difficulties in defining services income and distinguishing it from sales income and/or royalties.  Again, the USCIB recommends that any issues arising in this context be resolved through the application of a facts and circumstances approach.  A careful analysis of the facts and circumstances of transactions involving digitized information flow in a service environment should provide the appropriate tax treatment without the need to prescribe a new set of rules.

SERVICES INCOME SOURCE

Under the Code, the source of services income is the geographic location (i.e., country ) in which the services are physically performed.  The Treasury Paper considers whether the rendering of services remotely via electronic commerce will make this concept obsolete.  Under existing international rules, service income of a foreign service provider is only subject to host country income tax if the services are physically performed in the host country by employees, or other representatives, of the foreign service provider. Where the service provider can perform the services in its country of residence, in general, the foreign service provider will not be taxed in the host country, either on an “effectively connected”/net income basis or on a withholding/gross income basis.

The Treasury Paper notes that technology has weakened the connection between the location of the service provider and the location of the service consumer.  Even before the advent of the Internet, there were certain services that could be provided from outside the country of the consumer.  The long term trend will continue to move in the direction of providing more and more services remotely.  It will still be necessary, however, to render certain types of services in the host country.  The use of the Internet only represents a change in the facts and circumstances under which business is conducted, and, therefore, the source rule for services can be adapted to the new realities.  In accordance with these changed facts and circumstances, residence-based taxation will also become more prominent in this area, but this will occur again as a result of the changing environment, and should not be forced by way of statutory amendments.

The critical issue is not whether the predominant source rule of the industrialized countries is the more appropriate standard, but whether international harmony (i.e., consistency) can be achieved so as to avoid the potential for international double taxation.  This is particularly relevant to U.S. taxpayers.  Most countries use the place of performance test as a basis for sourcing services income.  Not an insignificant number of developing countries, however, use a place of use test, which is in conflict with the place of performance test.  Under the place of use test, a U.S. company rendering services from the U.S. to a consumer located in a developing country will have its service fee income taxed in the host country, probably on a withholding tax basis (i.e., on a gross income basis).  For U.S. tax purposes, the income will constitute U.S. source income.  The dilemma is obvious, i.e., double taxation without foreign tax credit relief.  The income from the service fees will not be classified as foreign source income for U.S. tax purposes and, therefore, will not be in the numerator of the foreign tax credit limitation fraction.  Unless the taxpayer has other foreign source income which generates excess limitation, the foreign income tax on the service fees will constitute a double tax with no relief available.  This result represents an extra cost of doing business in developing countries.  The USCIB is not recommending a change to the place of use test; however, we would like to focus attention on an area where inconsistency of tax treatment between countries is already creating the potential for double taxation.  This situation will continue to increase as the Internet makes more likely the rendition of cross border services from the country of residence.  This is a matter which should be referred to an international body, such as the OECD, for its consideration.

GLOBAL ALLOCATION OF INCOME AND EXPENSES

Global trading has increased over the last decade from an almost insignificant level to the important role it now plays in the global economy.  This is a result of the trend away from regional and national economies to a global economy coupled with the technological explosion in telecommunications and information technologies.  In fact, as the Treasury Paper points out, global trading could not exist without this sophisticated technology.

Transfer pricing is the only issue that arises in this subject area.  This issue, however, should not be dealt with in the discussion of the tax consequences of electronic commerce.  Global trading already has been the topic of an OECD statement issued in the context of the OECD’s transfer pricing guidelines.  Ascertaining the appropriate allocation and apportionment of income and expenses arising from the cross-border trading of financial products is a matter of properly applying the arm’s-length standard, including the profit split method, to assign an appropriate portion of the global profit to the participating group affiliates.  The fact that so many of the global trading transfer pricing situations have been resolved by the Advanced Pricing Agreement program is not a direct concern or result of electronic commerce.  Accordingly, we do not think the subject should be included in further discussions of the taxation of electronic commerce.

ADMINISTRATIVE AND COMPLIANCE MATTERS

It may be true that the electronic medium has created more possibilities for the dishonest and criminally oriented to enter into profitable transactions, and more opportunities to hide such transactions from the scrutiny of the IRS.  The overwhelming majority of business taxpayers, however, particularly those included in the multinational corporate community (our membership), are honest taxpayers interested in enhancing their profitability worldwide through the use of legitimate means.

The USCIB believes that it is a worthy objective for the U.S. government and the governments of its trading partners to use its various powers to eliminate criminal activity of all kinds, including those that may be the result of the opportunities presented by the electronic medium.  Nonetheless, we do not favor any attempts to over-regulate and burden the multinational business community with far reaching information gathering and reporting requirements beyond those already in force.  Since 1963, the trend has been for the IRS to require more and more information from multinational taxpayers.  Currently, the information reporting demands of the Code and regulations impose a significant burden on multinational taxpayers, in terms of time and money.  It is for this reason that the USCIB urges that the U.S. government go very slowly in imposing another level of information reporting on the business community in an attempt to prevent  the criminal element from exploiting the electronic medium for criminal purposes. 

SUMMARY

The USCIB strongly endorses the continued application of the current US tax system to address the tax issues that may arise from use of the electronic medium for business purposes.  This is, as pointed out by the Treasury itself,  the surest way to achieve neutrality.  Stated another way, we reject the need for a new tax regime to deal with electronically consummated transactions, which, in essence, merely reflect a change in the facts and circumstances involved in these transactions.

The USCIB also maintains that an international consensus, as broadly constituted as possible, must be the ultimate goal of the US and its trading partners.  Such a solution is essential to minimizing international double taxation.  In this connection, we recommend the OECD as the international organization through which an appropriate consensus has the most favorable chances of being accomplished.